A chastened Wall Street emerges

AlistairBarr

SAN FRANCISCO (MarketWatch) -- One year since the collapse of Bear Stearns, a leading Wall Street analyst took time to revisit one of his memos.

"I just read the worst piece of research I've ever written," Brad Hintz said of his memo.

The piece was from August 2007 and the mortgage-fueled credit crisis had just gotten underway. In it Hintz, a Bernstein Research analyst, warned of pain to come, but he also asserted that Wall Street's top firms -- Goldman Sachs
GS, +0.17%
Morgan Stanley
MS, +0.34%
Merrill Lynch, Lehman Bros.
LEHMQ
and even Bear Stearns -- had the risk-management expertise and liquidity to survive.

What unfolded in the ensuing months was a historic financial meltdown that showed Hintz and many other experts were way off the mark about the soundness of the nation's leading brokerages. By mid-March 2008, Bear had collapsed into the arms of J.P. Morgan Chase
JPM, +0.43%
as trading partners and clients evaporated, making it impossible for the firm to meet its massive obligations. See full story.

At the time, many thought the government-engineered bailout of Bear marked a bottom in the mortgage crisis, but it was only the beginning.

Bear's failure exposed major flaws in the way Wall Street had worked so successfully for more than two decades. It also set the stage for the bankruptcy of Lehman six months later, which pitched the global economy into the deepest recession since the Great Depression.

"We thought that many of the old, basic rules of risk management and how to manage trading floors were right, but we were kidding ourselves," said Hintz, himself a former chief financial officer at Lehman and ex-treasurer of Morgan Stanley. "We've learnt that this event is unlike any other and that we were fighting yesterday's wars."

"We're all humbled and chastened," he added.

One of the main lessons from the current crisis is that Bear and others used too much leverage, or borrowed money, and relied too much on short-term sources of funding.

Regulation of brokerage firms was also weak, while compensation practices encouraged excessive risk-taking and didn't punish bankers enough when things went wrong.

"Bankers like to think there was this tsunami that washed them away, but that's just myth-making," said William Cohan, a former investment banker and author of a new book on the collapse of Bear called "House of Cards: A Tale of Hubris and Wretched Excess on Wall Street."

"The sooner they admit their role in inflating these bubbles with the desire for huge bonuses and a lavish lifestyles the better," he added.

In the 12 months since Bear went down, bad business practices on Wall Street already have undergone dramatic change in the face of intense pressure from investors and regulators.

Leverage has dropped, funding has firmed, compensation practices are being shaken up and some riskier businesses are withering.

"I'm very sanguine about how this is going to play out, even though it's quite painful at the moment," Cohan said. "Any detoxification process is painful -- ask any heroine addict. That doesn't mean the goal is not admirable. It's extremely necessary and important."

Debt addiction

For Wall Street, the addiction in question was debt.

In early 2007, Bear Stearns was hooked at record-high levels, sporting a so-called leverage ratio of 35 to 1: For every $1 in equity, it borrowed about $35 to hold a wide array of assets. Around the same time, Goldman, Morgan Stanley, Merrill and Lehman together averaged leverage ratios of 30 to 1, up from 20 to 1 in 2003, according to Bernstein research.

During good times, this helped fuel strong earnings as small gains in the value of assets translated into big returns on equity. But when the value of some assets began to fall, leverage magnified the losses and risked wiping out those thin slithers of equity.

By the time Lehman went bust in September, the search for more stable sources of funding became desperate.

Merrill's rushed sale to Bank of America
BAC, +0.61%
paired it with one of the nation's largest pools of retail bank deposits. This source of funding is more stable, so Goldman and Morgan Stanley quickly converted into bank holding companies to try to avoid the fate of Lehman and Bear.

"This is an historic change," Cohan said. "These firms have realized that deposits are a great source of funding, so they don't have to rely on the overnight repo market, which killed Bear and Lehman."

Morgan Stanley will likely build customer deposits by becoming the biggest retail broker, he added. In January, the firm agreed to take control of Citigroup's
C, -0.18%
Smith Barney brokerage business and hired the former head of Wachovia's big retail banking business.

Goldman may raise deposits by buying or growing a bank, Cohan said.

Leverage lowered

Meantime, Morgan and Goldman have also been busy selling assets and raising capital from private investors like Mitsubishi UFJ
MTU, +1.21%
and Berkshire Hathaway
BRK.A, +0.43%BRK.B, +0.46%
and via the first iteration of the government's Troubled Asset Relief Program, or TARP.

That's brought leverage ratios for these firms down a lot. Goldman's leverage ratio dropped 40% in 2008. Morgan Stanley's ratio was 11.4 to one at the end of November, down from 32.6 to one a year earlier.

As large bank holding companies, Goldman and Morgan Stanley will undergo the government's stress test. They may end up at the top of the class when the testing is finished by the end of April.

Morgan Stanley's tangible common equity ratio, a conservative measure of how much capital a bank has to absorb losses, is 4.4%. That's the highest among the largest U.S. banks, according to Richard Ramsden, an analyst at Goldman Sachs.

Investors are taking notice. Morgan Stanley shares have jumped 53% so far this year, while Goldman shares have rallied 15%. However, Citigroup, Bank of America and Wells Fargo
WFC, -0.26%
still are down 50% to 75% and the financials-heavy Standard & Poor's 500 index has lost 16%.

Skewed incentives

Reining in bad compensation practices will be among the necessary reforms, Wall Street experts say.

When investment banks were private partnerships, the partners had shared liability with each other.

"It was important that risks were prudent because the outcomes were shared by all partners of the firm," Cohan said.

Then Donaldson, Lufkin & Jenrette went public in 1970, a move that was followed by Merrill and most other large, private brokerage firms. Goldman's initial public offering was in 1999.

"There was a shifting of the incentives on Wall Street from risks taken and shared by your partners and to risks taken with no consequences to you individually," Cohan said. "If you took big risks and it paid off, you got a huge bonus, but if it didn't work out it hurt shareholders."

This was illustrated in outrageous fashion when Merrill closed out 2008 by paying $3.6 billion in bonuses to bankers while it shares slumped 78% and the firm lost $27.6 billion.

In the view of Cohan and other critics of compensation practices, that incentive structure is to blame for the market booms and busts of the past 25 years. Until it changes, "people are always going to do more and no one will say, 'I think we're going to stop now' in the middle of a boom,' " Cohan said.

Clawbacks

Change on that front has begun on Wall Street.

In the future, part of the year-end bonuses that Morgan Stanley pays will vest over three years and a chunk of that could be taken back if employees engage "in conduct detrimental to the firm," as Chief Executive John Mack put it in a December internal memo. Starting this year, Mack and other senior executives will be paid partly based on Morgan Stanley's performance over three years, rather than one.

New York State Attorney General Andrew Cuomo, Rep. Barney Frank and other lawmakers are discussing possible legislation that would accomplish the same goal of tying Wall Street pay to the long-term performance of firms.

Less profitable

But that's a ripple compared to the regulatory tidal wave washing over the remaining large investment banks in the U.S. and abroad.

A Securities and Exchange Commission program that is blamed for allowing a sharp increase in leverage at the five largest U.S. brokerages was scrapped in September.

The Group of Thirty, an international organization of central bank governors, leading economists, and private financial sector experts headed by Paul Volcker, has proposed restrictions on firms' private-equity businesses and limits on investment banks trading with their own money.

Volcker, a former Fed chairman and adviser to President Barack Obama, has also called for "a kind of two-tier financial system," recalling the Glass-Steagall Act, which separated commercial banks from investment banks during the Great Depression. The 1999 repeal of Glass-Steagall is widely seen as a turning point that freed commercial banks to get into riskier investment-banking activities.

Many observers believe that large investment banks generally will be less profitable because of tighter regulation and limits on leverage and riskier businesses.

Just converting to a banking holding company will bring a brokerage firm's return on equity down to 15.5% on average from 19% before, according to an estimate by Bernstein analyst Hintz.

Goldman's return on equity will probably fall more because it has more businesses that are capital-intensive, he added.

ROEs will likely be in the high 20% at the peak of future cycles. That's down from high 30% levels in the past, Kenneth Worthington, an analyst at J.P. Morgan Chase, said. See full story.

'Money on the table'

That has allowed smaller investment banks like Lazard
LAZ, -2.07%
Greenhill
GHL, -1.06%
and Evercore
EVR, -1.89%
to expand by hiring top bankers from larger firms shaken by the financial earthquake on Wall Street.

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